Commodities & Resources
Indicator
Commodities & Resources
Commodities & Resources October 2014 At a glance – Commodity and Resources equity views over the next 3-6 months Energy
Precious metals
Base & bulk metals
Ags & softs
Crude oil
Gold
Copper
Corn
Natural gas
Silver
Aluminium
Soybean
Refiners
Platinum
Zinc
Wheat
Palladium
Nickel
Palm oil
Diamonds
Iron ore
Potash
Coking coal
Nitrogen
Steel
Poultry
Oil services
n/a
Thermal coal Uranium
Commodity Neutral
Equity Strongly up
Sharply down
Trending up
Trending down
Views expressed for a resource equity sector are subjective and are for the sector as a whole. Investec will have different views for different stocks within that sector. As at 10 October 2014. All returns below in US dollars unless otherwise stated.
Market background September was a particularly poor month for commodities and resource equities with most commodities suffering due to the stronger US dollar. Chinese data continued to lose momentum, as evident through the deterioration of a broader set of indicators (industrial production, retail sales and fixed asset investment) which has heightened talk of a slowdown. The Bloomberg Commodity Index fell 6.2%, while resource equities, as measured by the MSCI Select Natural Resources Capped Index, declined 7.7%. Abundant global supply against the backdrop of a perceived slowdown in the Chinese economy hurt iron ore and steel prices over the month. The Chinese government’s stance on boosting stimulus is creating uncertainty. Increased LME stockpiles of nickel saw prices fall by over 13%. The MSCI ACWI Metals & Mining NTR fell 10.7%. Within precious metals, further US dollar strength, which climbed to fresh highs during the month, continued to push gold prices lower. Rumours of the sale of 2.4 million ounces of palladium from Russian stockpiles saw prices dip. Threats to supply and sanctions against Russia have been the foundation for palladium’s outperformance this year. Brent crude oil fell a further 8% in September as a combination of weak economic data from Europe and China and additional output from Libya and Iraq outweighed contagion fears from the US-led coalition airstrikes in the Middle East. US natural gas ended the month slightly up during this shoulder period. Overall the MSCI AC World Energy Index was down 7.8%. The expectation of a bumper US harvest continues to weigh on the broader grain and oilseed complex with corn, wheat and soybeans all down over 30% for the six months to 30 September. Within the protein space, US cattle and hog prices continue to hold up as supply growth remains constrained.
This communication is only for professional investors and professional financial advisors. It is not to be distributed to the public or within a country where such distribution would be contrary to applicable law or regulations.
Energy Oil Recent developments: Brent crude oil had a tough month, falling 8.0% in September to finish at $93.2 per barrel (bl). West Texas Intermediate (WTI) crude oil prices fell 5.0%, placing the differential between Brent and WTI at just over $2/bl. This is less than the approximate cost of transporting WTI from the terminal at Cushing, Oklahoma down to the Gulf Coast. However, what is of greater long-term significance is the move higher in long-dated Brent futures. As of 1 January 2014, Brent futures (2019) were trading at $85/bl, while spot Brent was just below $110/bl. Today, the 2019 contracts are approximately $95/bl, despite an $11/bl decline in the spot price. We believe this move up in the laterdated crude futures price should provide a positive signal for energy equity investors during a period of weakness. Short-term supply improvements from Libya and weaker global demand helped push the oil price lower. Weakness in demand was evident across the euro zone, as German and Italian GDP declined quarter on quarter, while French growth stagnated. Japanese demand was also weak, and although it is a seasonally soft period we saw total product demand trade below the historical five-year range. However, looking forward we are more positive — US demand figures look stronger while refinery utilisation levels are close to five-year seasonal highs. Oil’s poor performance can also be explained by the significant reduction in crude oil net speculative length, which according to the latest report has fallen approximately 7% over the month. There has also been a significant focus on the strong US dollar. The US Dollar Index (exchange rate between the US dollar and major world currencies) has strengthened by almost 4% during September. This has put pressure on a number of commodities whose fundamentals have weakened (Bloomberg Commodity Index down 6.2%). However, we believe this short-term inverse relationship will not last as there is no strong statistical relationship over the long term between oil prices and the US dollar. Market outlook: We have brought down our forecast price for Brent in 2014 given the recent drop in price and we now have an average price of $107/bl for the year. The first half average was $109/bl and the average for the second half of the year is looking weaker. We have been surprised by the soft demand numbers, particularly from Europe and Japan. GDP forecasts are generally trending lower, and while OECD oil inventories have loosened, we believe there are positive signs coming out of the US and signs of a seasonal rebound from China. However, we would caution that there remain significant risks to supply: Russia, Syria, Iraq, Libya and Gaza. The short-term focus is centred on poor demand statistics, but looking further down the line we remain concerned with global supply. Investment in new supply is being reduced due to geopolitical risk and capital constraints and this will be felt sharply in the second half of the decade.
Gas Recent developments: The Henry Hub natural gas price was marginally up during September, starting the month at $4.07 per thousand cubic feet (mcf) and finishing at $4.12/mcf, a rise of 1.38% over the period. The price traded within a reasonably narrow range and we believe the main driver of price over the next six months will be the weather. The futures curve is in contango (7% over two years) but the overall curve has shifted down over the past year by approximately 5%. (contango = futures price > spot price). Injections to storage were above average (and consensus) but we still sit below the five-year average (3,500 bcf) at 3,100 bcf. The latest Energy Information Administration (EIA) production data by state (July figures) shows a new record level for US natural gas production. This is the fifth consecutive month in which a new record has been established. The month-on-month increase was 0.35 billion cubic feet (bcf) per day, taking the absolute gross production level to 79.1 bcf/d. Once again, ‘other states’ (ie the Marcellus Basin) were the main drivers of growth, despite infrastructure constraints. The ‘other states’ production was up by 0.67 bcf/d m/m. Overall, the latest 2014 production numbers from the EIA show that production is 3.1 bcf/d higher than 2013’s peak in November. Market outlook: 2015 is setting up to be a weak year for US natural gas pricing. Associated gas from liquid plays, as well as Marcellus volumes, continue to keep the market well-supplied, even at sub-$4 spot prices. We expect to see continued production growth in 2015, and see the required demand uplift coming in 2016 to help balance the market. Exports will be the principal source of new demand, aided by continued industrial demand growth. The major unknown on the demand side remains the weather. Our modelling implies a normalised temperature through the 2014-15 winter but clearly a repeat of last year’s winter would draw more gas from storage. Hurricanes can also bring meaningful supply disruption. In this environment we expect Henry Hub prices to average $4/mcf in 2015, and strengthen again in 2016.
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Base & bulks Alumina Recent developments: Alumina is produced by refining bauxite and is the raw material used by aluminium smelters with approximately two tonnes of alumina needed to produce one tonne of metal. Many companies have integrated alumina and aluminium production, so in reality a much smaller proportion of the approximate 100 metric tonnes of alumina produced is actually traded. Oversupply in world markets has led to weaker prices over recent years, averaging about $320 per tonne (t) (FOB Australia) over the past two years, down from over $400/t in early 2011. However, with Rio Tinto having shut their Gove alumina refinery in Australia at the end of May this year, thus removing around 3% of world supply, along with an accident at one of Chalco’s Chinese plants and a potential strike looming at Glencore’s Sherwin Alumina plant in the US, the market has begun to tighten up in recent weeks. Prices rose from just over $305/t in June to $357/t by the end of September and are 9% higher than at the beginning of the year. Market outlook: Alumina markets are changing rapidly after several years in the doldrums as rising aluminium prices are incentivising potential smelter restarts and thus increased alumina demand just as capacity growth has stopped. The ban on exports of bauxite from Indonesia is also starting to have an effect as Chinese alumina refineries are due to deplete stocks of Indonesian bauxite built up last year ahead of the ban and will need to go elsewhere as domestic reserves are lower quality and more expensive. While Rio Tinto has shut alumina production at Gove, it is now increasing exports of bauxite from its Weipa mine directly to China but this will only partially replace the alumina from Gove and will not make up for the fall in supply from Indonesia. With alumina prices trading at their cheapest relative to aluminium since 2009, it looks likely that prices will continue to rise into year end.
Zinc Recent developments: Zinc prices fell 3.0% in September to close at $2,288/t but still managed to outperform the rest of the base metals. Year to date, prices are still up 11.3% and nearly 20% over the past twelve months. Chinese imports of refined zinc are up 40% year-on-year over the first seven months as Chinese mine supply has shown no growth after several years of nearly 10% per annum rises. This, combined with falling western world mine production has moved the market into deficit which looks likely to get worse in 2015 as planned closures for its Century and Lisheen mines will reduce world mine supply by 7%. Zinc inventories have shown little change over the summer as a small rise in LME stocks has been largely offset by a fall in Shanghai Futures Exchange stocks but they are still 238,000 tonne lower than at the start of the year. With summer holidays over and Chinese national holidays finishing this week, inventories look set to fall into year end. Market outlook: Reports of weaker demand from Chinese and European steel mills in recent weeks have led to concerns that zinc premia and prices will come under further pressure, exacerbated by the stronger US dollar. However, we believe that the growth galvanising in China is a structural change as consumers demand better quality – cars which rust in three years are no longer acceptable in China – and mills strive to develop more demanding export markets. So while there may be some short-term destocking, demand growth looks set to resume into 2015 and there is not the supply growth to match it. This is underlined by Glencore’s recent Australian site visit where they reduced their zinc production target for this year by 100,000 tonnes with a further 70,000 tonnes reduction the year after as their expansions have been delayed. Unlike commodities such as iron and copper, the supply growth required to balance this market is missing and thus prices look set to move higher over the next twelve months.
Precious metals Gold Recent developments: Gold experienced its largest monthly fall for 2014 in September, falling over 6% to close at $1,208 per ounce (oz). A number of factors contributed to the decline: a strong US dollar, weak physical demand out of Asia, falling inflation and, as a result of these factors, a further reduction in futures’ net length. The US dollar continued to strengthen, rising nearly 4% over the month and 8% for the quarter. This sharp appreciation has proved a major headwind for all commodities including gold. As we have mentioned previously, the second half of the year is typically a stronger seasonal period for gold. However, the seasonality trade has not worked so well this year and price action over the summer has followed this trend. July, August and September are typically gold’s strongest performing months, but gold dropped 3.4% in July, did very little in August and September proved even worse. Indian demand remains subdued as import restrictions remain in place and the Chinese appear to have ample inventory to meet current demand needs.
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One of the bullish arguments for future gold prices is higher inflation. The effects of very low interest rates and quantitative easing have created significant quantities of money which at some point might create inflationary pressures. There was evidence this was playing out in the first half of the year with core inflation in the US on the up. However, the most recent data point in August showed inflation fell to 1.7%. Furthermore, with commodity prices falling, most notably oil and grains, the likelihood of near-term supply side inflationary pressures is diminishing. Market outlook: Gold remains under pressure and this is likely to continue for the foreseeable future as long as economic data, particularly in the US, remains buoyant. Quantitative easing should end in the coming months, so future guidance on interest rates will become increasingly important. Both the Fed and the market have moved their expectations of interest rate increases forward and this continues to weigh on the gold price. More positively, on the 30 November 2014 Switzerland will vote on bolstering its gold reserves. The Swiss Gold Initiative has three stipulations: 1) the SNB holds at least 20% of its assets in gold, 2) the SNB does not sell any of its gold reserves, and 3) all of the SNB’s gold is stored in Switzerland. If passed, and currently very few are talking about it outside of Switzerland, the SNB would need to buy 1,500 tonnes over a three-year period, which equates to half of the world’s annual production.
Platinum Recent developments: Platinum endured a very weak monthly performance, taking its cue from gold and the precious metals sector more broadly. The metal was down 8.86% for September closing at 1,299/oz. A stronger US dollar effected all commodities but the effect was acutely felt by the precious metal sector. Weak seasonal demand coupled with a healthy US economy contributed to the weak performance. Platinum underperformed gold as global platinum inventories remain healthy and Europe, a key driver for auto catalyst demand, remains weak. Encouragingly we did see evidence of strong physical buying on price weakness. Market outlook: Platinum is set to be in further deficit in 2014 and 2015. The five-month strike of 2014 will not only have implications for immediate production but also longer term targets. Companies are unwilling to allocate significant capital to labour intensive new mines. This lack of capital now will have implications for production in for the next 5-10 years. Demand across vehicle applications and in Chinese jewellery remains buoyant.
Agriculture & softs Corn Recent developments: With the US harvest now underway with favourable weather conditions continuing, the price of the front month CBOT corn contract fell 10.7% in September to a four-year low of $3.20 per bushel (bu). Other staple agricultural commodities also declined, and YTD corn, wheat and soybeans are now down 23.9%, 20.9% and 30.2% respectively. The US Department of Agriculture estimate for the US corn crop yield increased by over 4 bushels to 171.7 bu/acre for the month, which was above market expectations. Corn’s condition rating has been maintained at 74% good-to-excellent, compared to the 10-year average of 57% and 53% a year ago. Given the forecasted size of this US crop and the high 2013/14 ending stocks of 1.24 billion bushels, production in other regions has not driven market movements. Market outlook: This is the best rated crop in 20 years and with the crop maturity lagging the seasonal average, the benign weather should lead to increased ear weights. With the harvest now over 12% complete at the start of October, further clarity is being gained that the official yield will be increased. Some outliers are even estimating yields of 180bu/acre. Fundamentals remain bearish as early frost seems unlikely to occur and rains are not expected to delay the harvest of the remaining crop. This should dampen any attempt at a short covering rally, especially given the uncompetitiveness of the crop in international markets given the strength of the US dollar.
Potash Recent developments: Vancouver (standard) potash prices, a dominant global index, are now $282 per metric tonne at the end of September, after reaching lows of $280/t in February 2014. Encouraged by higher volume levels in Brazil and in Chinese ports, prices in Brazil which historically trade at a premium, have been pushing upwards. Canpotex’s announcement to increase prices in south-east Asia to $350/t from $320/t coincided with Uralkali’s announcement of a 5-$10/t October increase in China from the current $305/t for the 2015 contract. Global producers increased prices in Brazil to $380/t for October delivery of premium granular product, with demand in this region being particularly strong. Stronger-than-expected demand has also contributed to higher global prices as the supply chain restocks following the harsh winter in North America which hampered logistics of the product. More recently, the outage in Agrium’s Vanscoy mine as well as the slow pace of production at Mosaic’s Esterhazy facility, has reduced supply and supported the trend of rising prices. 4
Market outlook: China imported 16% year on year more potash in the first eight months of 2014. Belarus and Russia are maintaining their combined market share in the Chinese market of approximately 48% with Uralkali giving some 4% of that market share to Belaruskali proving that the relationship between these producers may be normalising. However, announcements from the chief executive officer of Uralkali supports our belief that the formation of a Belarussian Potash Company #2 is unlikely in the short term but remains a longer-term possibility. Although 2014 has seen some reprieve to the downward momentum in prices, demand in 2015 is still a large concern for this structurally oversupplied market. Potash Corp. expects 2015 global demand to be in the range of 58-60 million tonnes, which would be a year-on-year increase of between 1-3 million tonnes. With operating rates below historical levels, especially at Potash Corp, the main driver of prices in the next 12 months will come from the Chinese contract, which we expect to stay around current levels.
Thought for the month: Pullback in the energy space – at odds with strengthening fundamentals What has happened? September has seen a sharp pullback in the global energy sector with the benchmark losing 8%.We strongly believe this pull back is a temporary feature, and at odds with strengthening longer-term fundamentals. We see a great opportunity for the sector to recover strongly over the next 6 months, and we have used the pullback to further add to the portfolio. The ‘headline’ price for oil is the spot price for immediate crude deliveries; this has fallen by 17.5%, since it peaked on 19 June. However, over the last 6 months, prices for future deliveries have risen strongly (see chart below, almost $10/b in 2020), as oil traders are slowly understanding the structural difficulties of adding crude supply outside North America. Unfortunately, the fortunes of the sector and the Global Energy portfolios we manage have followed the headline price, failing to recognise that the value of the sector should be defined by prices over time. A simple DCF valuation for a 20-year oil development shows that the recent changes in oil price forward curve should have added value to the sector (+18% using a 10% discount factor). Prices for future deliveries have risen strongly 110
105
$/bbl
100
95
90
85 May 14
May 15
May 16
Crude Oil, Brent: 10.03.2014
May 17
May 18
May 19
May 20
May 21
Crude Oil, Brent: 1 year prior
Source: Bloomberg, 10.03.14
What is behind the recent slump in the oil price? Several factors have combined to put pressure on the oil price: • A strengthening dollar and the assumption that this is negative for commodities. • Weaker demand than anticipated, particularly in Japan and Europe. • The anticipation that a slowing Chinese economy will put further pressure on demand. • Inventories that have been growing through the summer. • Imminent refinery maintenance season. • A conspiracy theory that Saudis will not cut back production to put pressure on ISIS.
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Why we feel sentiment on these factors will improve by the year-end • Whilst we anticipate a continued strong dollar environment, history shows that there is very little correlation between USD strength and the oil price (14% R 2 correlation): strong economic performance from the world’s largest demand centre is often positive for oil demand. • Japanese demand has been impacted by recent consumption tax increases. As we head into winter in the northern hemisphere, with limited progress on nuclear power resumption, demand should pick up. European crude demand has been hit by refineries burning fuel oil rather than crude, this should reverse as refinery margins have increased recently incentivising higher activity. • Recent data from China demonstrates that any slowing in the China economy is not having a significant impact on crude demand growth; a sign of changing priorities for the Chinese consumer, where car sales are still growing at 7.7%/year. • The seasonal growth in inventories reverses as winter demand is higher. The Saudi fields are run hardest during the summer, when up to 1mb/d of crude is burnt by domestic generators for the increased air-conditioning demand. In winter the Saudis run maintenance, so production needs to be cut back. • US refineries tend to go down for refinery maintenance in October, but only for a short period. US refined product stocks are well below 5-yr normal levels, even after record utilisation levels, so, with good refining margins, refiners are incentivised to reduce maintenance periods. European and Asian refining margins have also increased recently, so the impact of US maintenance should be reduced.
Validation of the longer-term investment case for energy Several factors are playing out that give us confidence that our longer-term investment themes are well supported. • The major integrated oil companies are tearing-up production targets and reducing capex programmes, which should further reduce production growth. • Exploration performance continues to be very weak, especially for oil. The major oil companies are cutting back and re-focusing exploration programmes; again supply will likely suffer. • These factors are leading to poor organic resource replacement, this means that inorganic replacement through acquisitions should come back into focus. • The market has rewarded the acquirer for the two big acquisitions this year in the US (Whiting for Kodiak, Encana for Athlon). Balance sheets amongst the large oils are very strong, so this pullback provides a good opportunity to improve efficient use of balance sheet capacity. Acquisition risk can be hedged out in a stronger futures market. • Whilst the US gas market looks weak, the international liquified natural gas (LNG) market has tightened after a weak summer. Winter energy balances look tight across Asia and Europe. • The US unconventional fracking revolution is still the majority of global oil production growth, as greater volumes of sand are pumped into wells. However the annual growth rate has now fallen to 1mb/d, considerably lower than the 1.2mb/d delivered this time last year. • OPEC’s growth engine is Iraq. The rise of ISIS has already reduced activity and investment. • Russia, the world’s largest crude producer, is suffering from sanctions, particularly access to funding.
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What have we done with the portfolio? We have used the market pullback to add some additional quality stocks that previously we found to have insufficient upside. Whilst we believe that Brent crude price weakness is reaching a bottom, we anticipate further relative weakness for US domestic crudes, which is beneficial for US refiners. • Added quality US and Canadian oil E&P exposure, beneficiaries of stronger oil forward prices and potential sector consolidation: EOG Resources and Laredo Petroleum. • Added Refining exposure, beneficiaries of lower crude prices and potentially increased US crude differentials: reintroduced Valero (US refiner) and SK Innovation (Korean refiner). • Reduced oilfield service exposure; concentrating on companies with strong US exposure, or high levels of visible backlog. • Reduced exposure to emerging market oils, where political, dividend and currency risk has increased. Our analysis demonstrates that stocks in the portfolio are now reflecting oil prices of below $80/b; we calculate an average upside of over 50% for the portfolio.
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Important information This document is not for general public distribution. If you are a private investor and receive it as part of a general circulation, please contact us at +44 207 597 1900. The information discusses general market activity or industry trends and should not be construed as investment advice. The economic and market forecasts presented herein reflect our judgment as at the date shown and are subject to change without notice. These forecasts will be affected by changes in interest rates, general market conditions and other political, social and economic developments. There can be no assurance that these forecasts will be achieved. Investors are not certain to make profits; losses may be made. The information contained in this document is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly held but are not guaranteed and should not be relied upon. This communication is provided for general information only. It is not an invitation to make an investment nor does it constitute an offer for sale and is not a buy, sell or hold recommendation for any particular investment. In the US, this communication should only be read by institutional investors, professional financial advisers and, at their exclusive discretion, their eligible clients, but must not be distributed to US persons. In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001). All data sourced from Bloomberg and Investec Asset Management. Outside the US, telephone calls may be recorded for training and quality assurance purposes. Issued by Investec Asset Management, October 2014.
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Commodities & Resources
Commodities & Resources October 2014 At a glance – Commodity and Resources equity views over the next 3-6 months Energy
Precious metals
Base & bulk metals
Ags & softs
Crude oil
Gold
Copper
Corn
Natural gas
Silver
Aluminium
Soybean
Refiners
Platinum
Zinc
Wheat
Palladium
Nickel
Palm oil
Diamonds
Iron ore
Potash
Coking coal
Nitrogen
Steel
Poultry
Oil services
n/a
Thermal coal Uranium
Commodity Neutral
Equity Strongly up
Sharply down
Trending up
Trending down
Views expressed for a resource equity sector are subjective and are for the sector as a whole. Investec will have different views for different stocks within that sector. As at 10 October 2014. All returns below in US dollars unless otherwise stated.
Market background September was a particularly poor month for commodities and resource equities with most commodities suffering due to the stronger US dollar. Chinese data continued to lose momentum, as evident through the deterioration of a broader set of indicators (industrial production, retail sales and fixed asset investment) which has heightened talk of a slowdown. The Bloomberg Commodity Index fell 6.2%, while resource equities, as measured by the MSCI Select Natural Resources Capped Index, declined 7.7%. Abundant global supply against the backdrop of a perceived slowdown in the Chinese economy hurt iron ore and steel prices over the month. The Chinese government’s stance on boosting stimulus is creating uncertainty. Increased LME stockpiles of nickel saw prices fall by over 13%. The MSCI ACWI Metals & Mining NTR fell 10.7%. Within precious metals, further US dollar strength, which climbed to fresh highs during the month, continued to push gold prices lower. Rumours of the sale of 2.4 million ounces of palladium from Russian stockpiles saw prices dip. Threats to supply and sanctions against Russia have been the foundation for palladium’s outperformance this year. Brent crude oil fell a further 8% in September as a combination of weak economic data from Europe and China and additional output from Libya and Iraq outweighed contagion fears from the US-led coalition airstrikes in the Middle East. US natural gas ended the month slightly up during this shoulder period. Overall the MSCI AC World Energy Index was down 7.8%. The expectation of a bumper US harvest continues to weigh on the broader grain and oilseed complex with corn, wheat and soybeans all down over 30% for the six months to 30 September. Within the protein space, US cattle and hog prices continue to hold up as supply growth remains constrained.
This communication is only for professional investors and professional financial advisors. It is not to be distributed to the public or within a country where such distribution would be contrary to applicable law or regulations.
Energy Oil Recent developments: Brent crude oil had a tough month, falling 8.0% in September to finish at $93.2 per barrel (bl). West Texas Intermediate (WTI) crude oil prices fell 5.0%, placing the differential between Brent and WTI at just over $2/bl. This is less than the approximate cost of transporting WTI from the terminal at Cushing, Oklahoma down to the Gulf Coast. However, what is of greater long-term significance is the move higher in long-dated Brent futures. As of 1 January 2014, Brent futures (2019) were trading at $85/bl, while spot Brent was just below $110/bl. Today, the 2019 contracts are approximately $95/bl, despite an $11/bl decline in the spot price. We believe this move up in the laterdated crude futures price should provide a positive signal for energy equity investors during a period of weakness. Short-term supply improvements from Libya and weaker global demand helped push the oil price lower. Weakness in demand was evident across the euro zone, as German and Italian GDP declined quarter on quarter, while French growth stagnated. Japanese demand was also weak, and although it is a seasonally soft period we saw total product demand trade below the historical five-year range. However, looking forward we are more positive — US demand figures look stronger while refinery utilisation levels are close to five-year seasonal highs. Oil’s poor performance can also be explained by the significant reduction in crude oil net speculative length, which according to the latest report has fallen approximately 7% over the month. There has also been a significant focus on the strong US dollar. The US Dollar Index (exchange rate between the US dollar and major world currencies) has strengthened by almost 4% during September. This has put pressure on a number of commodities whose fundamentals have weakened (Bloomberg Commodity Index down 6.2%). However, we believe this short-term inverse relationship will not last as there is no strong statistical relationship over the long term between oil prices and the US dollar. Market outlook: We have brought down our forecast price for Brent in 2014 given the recent drop in price and we now have an average price of $107/bl for the year. The first half average was $109/bl and the average for the second half of the year is looking weaker. We have been surprised by the soft demand numbers, particularly from Europe and Japan. GDP forecasts are generally trending lower, and while OECD oil inventories have loosened, we believe there are positive signs coming out of the US and signs of a seasonal rebound from China. However, we would caution that there remain significant risks to supply: Russia, Syria, Iraq, Libya and Gaza. The short-term focus is centred on poor demand statistics, but looking further down the line we remain concerned with global supply. Investment in new supply is being reduced due to geopolitical risk and capital constraints and this will be felt sharply in the second half of the decade.
Gas Recent developments: The Henry Hub natural gas price was marginally up during September, starting the month at $4.07 per thousand cubic feet (mcf) and finishing at $4.12/mcf, a rise of 1.38% over the period. The price traded within a reasonably narrow range and we believe the main driver of price over the next six months will be the weather. The futures curve is in contango (7% over two years) but the overall curve has shifted down over the past year by approximately 5%. (contango = futures price > spot price). Injections to storage were above average (and consensus) but we still sit below the five-year average (3,500 bcf) at 3,100 bcf. The latest Energy Information Administration (EIA) production data by state (July figures) shows a new record level for US natural gas production. This is the fifth consecutive month in which a new record has been established. The month-on-month increase was 0.35 billion cubic feet (bcf) per day, taking the absolute gross production level to 79.1 bcf/d. Once again, ‘other states’ (ie the Marcellus Basin) were the main drivers of growth, despite infrastructure constraints. The ‘other states’ production was up by 0.67 bcf/d m/m. Overall, the latest 2014 production numbers from the EIA show that production is 3.1 bcf/d higher than 2013’s peak in November. Market outlook: 2015 is setting up to be a weak year for US natural gas pricing. Associated gas from liquid plays, as well as Marcellus volumes, continue to keep the market well-supplied, even at sub-$4 spot prices. We expect to see continued production growth in 2015, and see the required demand uplift coming in 2016 to help balance the market. Exports will be the principal source of new demand, aided by continued industrial demand growth. The major unknown on the demand side remains the weather. Our modelling implies a normalised temperature through the 2014-15 winter but clearly a repeat of last year’s winter would draw more gas from storage. Hurricanes can also bring meaningful supply disruption. In this environment we expect Henry Hub prices to average $4/mcf in 2015, and strengthen again in 2016.
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Base & bulks Alumina Recent developments: Alumina is produced by refining bauxite and is the raw material used by aluminium smelters with approximately two tonnes of alumina needed to produce one tonne of metal. Many companies have integrated alumina and aluminium production, so in reality a much smaller proportion of the approximate 100 metric tonnes of alumina produced is actually traded. Oversupply in world markets has led to weaker prices over recent years, averaging about $320 per tonne (t) (FOB Australia) over the past two years, down from over $400/t in early 2011. However, with Rio Tinto having shut their Gove alumina refinery in Australia at the end of May this year, thus removing around 3% of world supply, along with an accident at one of Chalco’s Chinese plants and a potential strike looming at Glencore’s Sherwin Alumina plant in the US, the market has begun to tighten up in recent weeks. Prices rose from just over $305/t in June to $357/t by the end of September and are 9% higher than at the beginning of the year. Market outlook: Alumina markets are changing rapidly after several years in the doldrums as rising aluminium prices are incentivising potential smelter restarts and thus increased alumina demand just as capacity growth has stopped. The ban on exports of bauxite from Indonesia is also starting to have an effect as Chinese alumina refineries are due to deplete stocks of Indonesian bauxite built up last year ahead of the ban and will need to go elsewhere as domestic reserves are lower quality and more expensive. While Rio Tinto has shut alumina production at Gove, it is now increasing exports of bauxite from its Weipa mine directly to China but this will only partially replace the alumina from Gove and will not make up for the fall in supply from Indonesia. With alumina prices trading at their cheapest relative to aluminium since 2009, it looks likely that prices will continue to rise into year end.
Zinc Recent developments: Zinc prices fell 3.0% in September to close at $2,288/t but still managed to outperform the rest of the base metals. Year to date, prices are still up 11.3% and nearly 20% over the past twelve months. Chinese imports of refined zinc are up 40% year-on-year over the first seven months as Chinese mine supply has shown no growth after several years of nearly 10% per annum rises. This, combined with falling western world mine production has moved the market into deficit which looks likely to get worse in 2015 as planned closures for its Century and Lisheen mines will reduce world mine supply by 7%. Zinc inventories have shown little change over the summer as a small rise in LME stocks has been largely offset by a fall in Shanghai Futures Exchange stocks but they are still 238,000 tonne lower than at the start of the year. With summer holidays over and Chinese national holidays finishing this week, inventories look set to fall into year end. Market outlook: Reports of weaker demand from Chinese and European steel mills in recent weeks have led to concerns that zinc premia and prices will come under further pressure, exacerbated by the stronger US dollar. However, we believe that the growth galvanising in China is a structural change as consumers demand better quality – cars which rust in three years are no longer acceptable in China – and mills strive to develop more demanding export markets. So while there may be some short-term destocking, demand growth looks set to resume into 2015 and there is not the supply growth to match it. This is underlined by Glencore’s recent Australian site visit where they reduced their zinc production target for this year by 100,000 tonnes with a further 70,000 tonnes reduction the year after as their expansions have been delayed. Unlike commodities such as iron and copper, the supply growth required to balance this market is missing and thus prices look set to move higher over the next twelve months.
Precious metals Gold Recent developments: Gold experienced its largest monthly fall for 2014 in September, falling over 6% to close at $1,208 per ounce (oz). A number of factors contributed to the decline: a strong US dollar, weak physical demand out of Asia, falling inflation and, as a result of these factors, a further reduction in futures’ net length. The US dollar continued to strengthen, rising nearly 4% over the month and 8% for the quarter. This sharp appreciation has proved a major headwind for all commodities including gold. As we have mentioned previously, the second half of the year is typically a stronger seasonal period for gold. However, the seasonality trade has not worked so well this year and price action over the summer has followed this trend. July, August and September are typically gold’s strongest performing months, but gold dropped 3.4% in July, did very little in August and September proved even worse. Indian demand remains subdued as import restrictions remain in place and the Chinese appear to have ample inventory to meet current demand needs.
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One of the bullish arguments for future gold prices is higher inflation. The effects of very low interest rates and quantitative easing have created significant quantities of money which at some point might create inflationary pressures. There was evidence this was playing out in the first half of the year with core inflation in the US on the up. However, the most recent data point in August showed inflation fell to 1.7%. Furthermore, with commodity prices falling, most notably oil and grains, the likelihood of near-term supply side inflationary pressures is diminishing. Market outlook: Gold remains under pressure and this is likely to continue for the foreseeable future as long as economic data, particularly in the US, remains buoyant. Quantitative easing should end in the coming months, so future guidance on interest rates will become increasingly important. Both the Fed and the market have moved their expectations of interest rate increases forward and this continues to weigh on the gold price. More positively, on the 30 November 2014 Switzerland will vote on bolstering its gold reserves. The Swiss Gold Initiative has three stipulations: 1) the SNB holds at least 20% of its assets in gold, 2) the SNB does not sell any of its gold reserves, and 3) all of the SNB’s gold is stored in Switzerland. If passed, and currently very few are talking about it outside of Switzerland, the SNB would need to buy 1,500 tonnes over a three-year period, which equates to half of the world’s annual production.
Platinum Recent developments: Platinum endured a very weak monthly performance, taking its cue from gold and the precious metals sector more broadly. The metal was down 8.86% for September closing at 1,299/oz. A stronger US dollar effected all commodities but the effect was acutely felt by the precious metal sector. Weak seasonal demand coupled with a healthy US economy contributed to the weak performance. Platinum underperformed gold as global platinum inventories remain healthy and Europe, a key driver for auto catalyst demand, remains weak. Encouragingly we did see evidence of strong physical buying on price weakness. Market outlook: Platinum is set to be in further deficit in 2014 and 2015. The five-month strike of 2014 will not only have implications for immediate production but also longer term targets. Companies are unwilling to allocate significant capital to labour intensive new mines. This lack of capital now will have implications for production in for the next 5-10 years. Demand across vehicle applications and in Chinese jewellery remains buoyant.
Agriculture & softs Corn Recent developments: With the US harvest now underway with favourable weather conditions continuing, the price of the front month CBOT corn contract fell 10.7% in September to a four-year low of $3.20 per bushel (bu). Other staple agricultural commodities also declined, and YTD corn, wheat and soybeans are now down 23.9%, 20.9% and 30.2% respectively. The US Department of Agriculture estimate for the US corn crop yield increased by over 4 bushels to 171.7 bu/acre for the month, which was above market expectations. Corn’s condition rating has been maintained at 74% good-to-excellent, compared to the 10-year average of 57% and 53% a year ago. Given the forecasted size of this US crop and the high 2013/14 ending stocks of 1.24 billion bushels, production in other regions has not driven market movements. Market outlook: This is the best rated crop in 20 years and with the crop maturity lagging the seasonal average, the benign weather should lead to increased ear weights. With the harvest now over 12% complete at the start of October, further clarity is being gained that the official yield will be increased. Some outliers are even estimating yields of 180bu/acre. Fundamentals remain bearish as early frost seems unlikely to occur and rains are not expected to delay the harvest of the remaining crop. This should dampen any attempt at a short covering rally, especially given the uncompetitiveness of the crop in international markets given the strength of the US dollar.
Potash Recent developments: Vancouver (standard) potash prices, a dominant global index, are now $282 per metric tonne at the end of September, after reaching lows of $280/t in February 2014. Encouraged by higher volume levels in Brazil and in Chinese ports, prices in Brazil which historically trade at a premium, have been pushing upwards. Canpotex’s announcement to increase prices in south-east Asia to $350/t from $320/t coincided with Uralkali’s announcement of a 5-$10/t October increase in China from the current $305/t for the 2015 contract. Global producers increased prices in Brazil to $380/t for October delivery of premium granular product, with demand in this region being particularly strong. Stronger-than-expected demand has also contributed to higher global prices as the supply chain restocks following the harsh winter in North America which hampered logistics of the product. More recently, the outage in Agrium’s Vanscoy mine as well as the slow pace of production at Mosaic’s Esterhazy facility, has reduced supply and supported the trend of rising prices. 4
Market outlook: China imported 16% year on year more potash in the first eight months of 2014. Belarus and Russia are maintaining their combined market share in the Chinese market of approximately 48% with Uralkali giving some 4% of that market share to Belaruskali proving that the relationship between these producers may be normalising. However, announcements from the chief executive officer of Uralkali supports our belief that the formation of a Belarussian Potash Company #2 is unlikely in the short term but remains a longer-term possibility. Although 2014 has seen some reprieve to the downward momentum in prices, demand in 2015 is still a large concern for this structurally oversupplied market. Potash Corp. expects 2015 global demand to be in the range of 58-60 million tonnes, which would be a year-on-year increase of between 1-3 million tonnes. With operating rates below historical levels, especially at Potash Corp, the main driver of prices in the next 12 months will come from the Chinese contract, which we expect to stay around current levels.
Thought for the month: Pullback in the energy space – at odds with strengthening fundamentals What has happened? September has seen a sharp pullback in the global energy sector with the benchmark losing 8%.We strongly believe this pull back is a temporary feature, and at odds with strengthening longer-term fundamentals. We see a great opportunity for the sector to recover strongly over the next 6 months, and we have used the pullback to further add to the portfolio. The ‘headline’ price for oil is the spot price for immediate crude deliveries; this has fallen by 17.5%, since it peaked on 19 June. However, over the last 6 months, prices for future deliveries have risen strongly (see chart below, almost $10/b in 2020), as oil traders are slowly understanding the structural difficulties of adding crude supply outside North America. Unfortunately, the fortunes of the sector and the Global Energy portfolios we manage have followed the headline price, failing to recognise that the value of the sector should be defined by prices over time. A simple DCF valuation for a 20-year oil development shows that the recent changes in oil price forward curve should have added value to the sector (+18% using a 10% discount factor). Prices for future deliveries have risen strongly 110
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Crude Oil, Brent: 10.03.2014
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Crude Oil, Brent: 1 year prior
Source: Bloomberg, 10.03.14
What is behind the recent slump in the oil price? Several factors have combined to put pressure on the oil price: • A strengthening dollar and the assumption that this is negative for commodities. • Weaker demand than anticipated, particularly in Japan and Europe. • The anticipation that a slowing Chinese economy will put further pressure on demand. • Inventories that have been growing through the summer. • Imminent refinery maintenance season. • A conspiracy theory that Saudis will not cut back production to put pressure on ISIS.
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Why we feel sentiment on these factors will improve by the year-end • Whilst we anticipate a continued strong dollar environment, history shows that there is very little correlation between USD strength and the oil price (14% R 2 correlation): strong economic performance from the world’s largest demand centre is often positive for oil demand. • Japanese demand has been impacted by recent consumption tax increases. As we head into winter in the northern hemisphere, with limited progress on nuclear power resumption, demand should pick up. European crude demand has been hit by refineries burning fuel oil rather than crude, this should reverse as refinery margins have increased recently incentivising higher activity. • Recent data from China demonstrates that any slowing in the China economy is not having a significant impact on crude demand growth; a sign of changing priorities for the Chinese consumer, where car sales are still growing at 7.7%/year. • The seasonal growth in inventories reverses as winter demand is higher. The Saudi fields are run hardest during the summer, when up to 1mb/d of crude is burnt by domestic generators for the increased air-conditioning demand. In winter the Saudis run maintenance, so production needs to be cut back. • US refineries tend to go down for refinery maintenance in October, but only for a short period. US refined product stocks are well below 5-yr normal levels, even after record utilisation levels, so, with good refining margins, refiners are incentivised to reduce maintenance periods. European and Asian refining margins have also increased recently, so the impact of US maintenance should be reduced.
Validation of the longer-term investment case for energy Several factors are playing out that give us confidence that our longer-term investment themes are well supported. • The major integrated oil companies are tearing-up production targets and reducing capex programmes, which should further reduce production growth. • Exploration performance continues to be very weak, especially for oil. The major oil companies are cutting back and re-focusing exploration programmes; again supply will likely suffer. • These factors are leading to poor organic resource replacement, this means that inorganic replacement through acquisitions should come back into focus. • The market has rewarded the acquirer for the two big acquisitions this year in the US (Whiting for Kodiak, Encana for Athlon). Balance sheets amongst the large oils are very strong, so this pullback provides a good opportunity to improve efficient use of balance sheet capacity. Acquisition risk can be hedged out in a stronger futures market. • Whilst the US gas market looks weak, the international liquified natural gas (LNG) market has tightened after a weak summer. Winter energy balances look tight across Asia and Europe. • The US unconventional fracking revolution is still the majority of global oil production growth, as greater volumes of sand are pumped into wells. However the annual growth rate has now fallen to 1mb/d, considerably lower than the 1.2mb/d delivered this time last year. • OPEC’s growth engine is Iraq. The rise of ISIS has already reduced activity and investment. • Russia, the world’s largest crude producer, is suffering from sanctions, particularly access to funding.
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What have we done with the portfolio? We have used the market pullback to add some additional quality stocks that previously we found to have insufficient upside. Whilst we believe that Brent crude price weakness is reaching a bottom, we anticipate further relative weakness for US domestic crudes, which is beneficial for US refiners. • Added quality US and Canadian oil E&P exposure, beneficiaries of stronger oil forward prices and potential sector consolidation: EOG Resources and Laredo Petroleum. • Added Refining exposure, beneficiaries of lower crude prices and potentially increased US crude differentials: reintroduced Valero (US refiner) and SK Innovation (Korean refiner). • Reduced oilfield service exposure; concentrating on companies with strong US exposure, or high levels of visible backlog. • Reduced exposure to emerging market oils, where political, dividend and currency risk has increased. Our analysis demonstrates that stocks in the portfolio are now reflecting oil prices of below $80/b; we calculate an average upside of over 50% for the portfolio.
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Important information This document is not for general public distribution. If you are a private investor and receive it as part of a general circulation, please contact us at +44 207 597 1900. The information discusses general market activity or industry trends and should not be construed as investment advice. The economic and market forecasts presented herein reflect our judgment as at the date shown and are subject to change without notice. These forecasts will be affected by changes in interest rates, general market conditions and other political, social and economic developments. There can be no assurance that these forecasts will be achieved. Investors are not certain to make profits; losses may be made. The information contained in this document is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly held but are not guaranteed and should not be relied upon. This communication is provided for general information only. It is not an invitation to make an investment nor does it constitute an offer for sale and is not a buy, sell or hold recommendation for any particular investment. In the US, this communication should only be read by institutional investors, professional financial advisers and, at their exclusive discretion, their eligible clients, but must not be distributed to US persons. In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001). All data sourced from Bloomberg and Investec Asset Management. Outside the US, telephone calls may be recorded for training and quality assurance purposes. Issued by Investec Asset Management, October 2014.
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